Email this article to a friend

Credit default swaps, a type of insurance against bond defaults that has become a hot topic for Wall Street policy makers in the last week, may have to migrate to an exchange if they are to continue to exist, according to a new report.

The swaps, which are designed to transfer the credit exposure of fixed-income products, have been singled out by regulators in recent weeks, with New York governor David Paterson announcing on Monday that the state planned to redefine the derivatives as insurance contracts, making them subject to oversight.

According to a report authored by Louis Purtle and Brian Yelvington, analysts at research firm CreditSights, the move by regulators could have unintended consequences.

The report said: "Insurable interest seems to be broadly defined as having a position in the underlying bonds that were referenced within the CDS contract. Though there are a myriad of workarounds to this type of regulations, to our thinking, this would effectively result in a two-price market where the cost of having a regulated insurer would be born via extra premium being paid by the purchaser of CDS."

The report added that this "bifurcation of the market" could add an extra layer of complexity in "a market that would greatly benefit from standardization and consolidation to provide transparency and liquidity."

The report suggests that CDS instruments should instead be migrated to an exchange, saying: "With fewer investment banks to provide liquidity, a rise in counterparty risk concerns owing to financial institution failures, and a push for regulation specifically targeting the CDS market, it appears to us that CDS might actually have to migrate to an exchange to exist.

"A central clearing house would provide transparency to the market, standardize initial margin bonds and help to mitigate counterparty exposures and risk concentrations."

The CDS market has come in for criticism for its part in the credit crunch, with UBS analyst Glenn Schorr dubbing the power the market holds over the economy as "insane."

Related

In a research note published last week, Schorr asked: "Isn't this a bit insane that the illiquid CDS market can decide the fate of these companies?" He was referring to Morgan Stanley and Goldman Sachs.

Christopher Cox, chairman of the Securities and Exchange Commission, waded into the debate yesterday, saying at a hearing before the Senate Committee on Banking, Housing and Urban Affairs that: "The $58 trillion (€42.1 trillion) credit default swap market is double the amount that it was in 2006 and is regulated by no one. Buyers of CDS do not have to own the underlying debt or bond and can short without any restriction so providing regulation will enhance investor protection."